Paul Howard explains why financial regulators want financial services firms to take a ‘brave’ lead in helping to manage the risk of a transition to a net-zero economy.
The current decade has often been called the “decisive decade” for taking action to limit global warming to 1.5C. But back in 2019, the UK financial regulator was already quite clear about supervisory expectations for the management of climate-related risks. That was despite there being no prescribed approach with everyone learning on the go.
Sarah Breeden, Executive Director of the Bank of England, has been a regular speaker on the topic of climate change and she gave her latest speech on the topic in April this year to Chapter Zero and the Global Association of Risk Professionals (GARP). It was called ‘‘Climate action – approaching a tipping point?’.
In it, she reflected on the collective progress made in getting to net zero since a speech she gave in 2020. She highlighted the latest IPCC synthesis report, which warns that we need to cut emissions by 40% in the current decade to limit warming to 1.5C. Unsurprisingly, global CO2 emissions continue to rise. Breeden argues that the government, companies, finance sector, and Bank of England must collaborate to meet this challenge.
Smooth the journey to net-zero
The journey to net-zero has three phases: identifying risks, building capability, and making business decisions to advance the transition. The banks and insurers are building their approach to climate risks and there has been a step change in this, with firms making more serious investments in developing capabilities to manage climate-related risks and in identifying opportunities. However, there are questions around whether these efforts are enough.
The Bank of England’s inaugural Climate Biennial Exploratory Scenario (CBES), run in 2021, shone a light on some opaque climate risks and on the need to build capabilities. It showed that costs were lowest and opportunities greatest with an early and well-managed transition. We have all had a recent lesson in the effects of a disorderly transition thanks to the Russian invasion of Ukraine. When the fossil fuel imports from Russia suddenly became unavailable, even nation-state resources were stretched in covering the shortfall. We must not waste those insights into our fossil-fuel dependency.
No ‘wait and see’
But, despite the hard energy lessons of the last winter, there is still foot dragging on the necessary changes. Some firms worry about imperfect information and limited ability to predict how new strategies will perform. In her speech in 2020 Sarah Breeden cautioned that: “It is better to be roughly right now than precisely right when it is too late.” There is clearly some frustration at the Bank about relative inaction and Breeden said in her April 2023 speech that: “We must not let perfection be the enemy of progress.” She warned that regulators have given firms a significant amount of homework to do and left the audience in no doubt that it would be marked rigorously.
As things stand, mandatory disclosures have delivered greater transparency and promoted the right conversations around board tables. Green finance has grown, but it has also brought associated challenges, including greenwashing. The biggest challenge remains filling the capability gap and equipping firms with forward-looking information so that they can allocate capital effectively and mobilise green finance at scale.
While progress is being made, though perhaps not at the pace hoped for, or required, when Sarah Breeden gave her original speech in 2020, there are legitimate reasons for delays –such as the pandemic and Russia’s invasion of Ukraine. However, those same reasons also increase the urgency to act. Financial services firms cannot delay taking action on climate change until they better understand how the transition may affect their business. Yes, as the Bank of England points out, there are significant gaps in the climate change understanding of banks’ clients. However, financial services firms are being pushed to help lead the way because they “sit at the centre of the economy”.
Success to the brave
The journey to net zero is an urgent and complex challenge that requires collaboration and action from all sectors of society – but financial services firms have a particularly important role to play. This is a time for banks to step forward and show the value that they provide for society in managing risk and enabling investment in the future.
Firms need to think far beyond business as usual, build expertise and capability, and act courageously against a backdrop of imperfect information. Regulators are no longer going to consider waiting for certainty and perfect information as acceptable excuses to go slowly. If nothing else, managing uncertainty is nothing new, firms do it all the time and, essentially, banks exist to manage risk. Sarah Breeden encouraged firms to “be brave” in action.
It’s sometimes said that life shrinks or expands in proportion to our courage. In a climate crisis, that is both literally and metaphorically true.